Stimulating The Employment Of Labor: Wrong

by Mario Rizzo  

Greg Mankiw juxtaposes opinion pieces by Paul Krugman and Gary Becker on dealing with the cyclical unemployment problem (aka “how to create jobs”). Becker’s blog post is especially worth reading.  

Whatever the political benefits of appearing to stimulate the employment of labor, the economic problem really shouldn’t be stated that way. We do not want to bias the system toward utilization of labor instead of other factors of production. I don’t think the distortions created by cheap credit should be remedied by trying to create further distortions. Most of Krugman’s suggestions are along these distortionary lines.  

…the federal government could provide jobs by … providing jobs. It’s time for at least a small-scale version of the New Deal’s Works Progress Administration, one that would offer relatively low-paying (but much better than nothing) public-service employment.  

…we can offer businesses direct incentives for employment. It’s probably too late for a job-conserving program, like the highly successful subsidy Germany offered to employers who maintained their work forces. But employers could be encouraged to add workers as the economy expands. The Economic Policy Institute proposes a tax credit for employers who increase their payrolls, which is certainly worth trying.  

Tax credits, especially, create all sorts of perverse incentives, as Becker explains. But, if successful, they impart a bias toward labor inputs.  

None of these suggestions exhibits the slightest understanding that labor markets need time to readjust. It is as if, for Krugman, some nasty irrational force has it in for labor employment (the “lagging indicator”). Yet entrepreneurs must figure out what the sustainable lines of production will be after a bubble period. All of this is presumably viewed as a minor issue because the major problem is consumers are too afraid to spend (on what?). Anything will do in Krugman’s world.  

On the other hand, Becker’s suggestions are more even-handed. 

I fully endorse Posner’s suggestions to cut the minimum wage, but I do not see that happening with the present Congress. My favorite approach it to try to stimulate the economy by cutting income taxes, especially corporate income taxes and other taxes on capital, both physical and human capital. Such tax cuts will stimulate investments in the economy, and in this way increase the demand for workers.  

They seek to lessen the tax burdens on labor and capital as well as the burden of the minimum wage. In principle, there is little to object to here.

On a related note, the contrast in the two sets of suggestions illustrates the difference between an economist who thinks that the current recession entails an indefinite suspension of the principles of microeconomics (Krugman) and one who is still concerned about incentives at the margin (Becker). 

Nevertheless, both economists are, I think, too much in the spell of the Principle of Aggregate Demand.  Aggregate demand theories abstract from concern about the need for readjustments in lines of production after credit-induced unsustainable sectoral expansions.

14 thoughts on “Stimulating The Employment Of Labor: Wrong

  1. Mario,

    With one exception, I think I agree with everything you said, including the point that Becker is still (rightly) thinking micro and both Krugman and Becker undervalue the problem of sectoral readjustment.

    You can probably guess the exception. You say, “We do not want to bias the system toward utilization of labor instead of other factors of production.” Isn’t this exactly what we want to do? The implied distortion is a bad thing, but surely unemployment is worse?

    Krugman’s suggestion seem mistaken to me too, but perhaps there is a more practical way to tilt the balance in favor of labor? Thinking out loud . . . How about if we temporarily reduce the FICA tax and phase it back in gradually? Wouldn’t that work directly on the unemployment rate and relieve, thereby, the distress of the unemployed and underemployed? We probably can’t compute the right reduction or the right rate of phase-back, but I should think any reasonable guess would create a beneficial boost to employment.

  2. My only comment was going to be to chide Becker for not clarifying that tax cuts to be effective must be permanent. Then Roger chimed in with an explicit recommendation for a temporary cut in FICA.

    Temporary tax cuts are ineffective. No one will create a permanent job for a temporary tax cut. By contrast, permanent tax cuts have immediate and permanent benefits. A cut in FICA in particular works on the supply side.

    Larry Lindsey had a plan for permanently cutting the payroll tax in half. Talk about a jobs bill!

    The flaw in any and all calls for tax cuts today is they lack credibility. One doesn’t need to believe in Ricardian Equivalence (which Ricardo himself did not) to predict that everyone knows taxes will rise. And entrepreneurs fear that much of the increase will fall on employment.

  3. You may be right, Jerry. I added the words “Thinking out loud” for a reason! But I’m not quite ready to back down yet. My proposal would not create permanent jobs it is true. But it was not meant to. Cyclical unemployment is a transient phenomenon and it seems reasonable to use transient measures to deal with it. In the long run, we don’t need any special measures to keep unemployment down. In the short run, however, unemployment is certainly a wretched for the jobless and often highly disruptive to the lives of the unemployed and their families.

  4. Roger,

    This issue was thrashed out over many years. If you accept the permanent income hypothesis and anything but static expectations, your reasoning and the proposed policy fail.

    Both employers and the workers they hire will understand any boost to profits and income is temporary. They will spend only the interest earned on the temporary inflows.

    Producton and hiring are financed by savings, which were severly depleted in the bust. Only higher future savings and capital formation will enable employment to rise permanently. Most (all?) of the stimulus is counter-productive for savings accumulation and capital formation.

    It is not as if these ideas were not tested in the New Deal (w/o the benefit of the General Theory). As Morganthau noted, after 6 years of the New Deal (1939), unemployment was as high as when they took over. All they had done was create a massive debt.

    The permanent recovery began when Roosevelt began a long-term naval building program in anticipation of the War AND then began abandoning the New Deal. The latter was hastened by the propect of a Republcian takeover of the House.

    This has absolutely nothing to do with one’s sympathy with the unemployed. Some problems cannot be imemdiately solved and take as long as they take to resolve. Unemployment payments are a palliative; they provide temporary help and unquestionably prolong unemployment. That is a tradeoff, but not in any case a solution.

    Believe it or not, all these problems used to be handled completely through private efforts of charity, church and family. And to a great extent they still are.

  5. Jerry,

    I don’t want to defend my suggestion too vigorously as I have thought about it by now for, like, 8 minutes or so. But I don’t see how your latest comments engage the issue. The permanent income hypothesis is about the consumption function, not labor demand. I am not calling for a reduction in the income tax, but in FICA, especially the employer’s share. I am not forgetting the tax incidence lecture we all give freshmen with, typically, FICA as the big example. But I don’t think labor supply is perfectly inelastic just now. Given wage rigidities, it probably matters in the short run whether you trim the employer’s or the employee’s nominal share.

    I don’t see how the New Deal is relevant either. I’m just talking about a tweak to one tax rate, not the New Deal.

    I am perfectly willing to believe that my idea would have minimal quantitative impact. Perhaps. Why not? But I don’t really see how the theory of the consumption function and the history of the New Deal give us information on that score.

    You do say that firms know “any boost to profits . . . is temporary” and “They will spend only the interest earned on the temporary inflows.” That tells us why my suggestion won’t do much for aggregate spending, but I was aiming at the unemployment rate. Again, I’m just not seeing the connection.

    Look, I don’t think I’m engaged in magical thinking or proposing a panacea. I’m just saying that cutting FICA (especially on the employer’s side) would nudge employment down. I don’t see why that modest claim is controversial. If I were to put it out there as a serious policy proposal I would be obliged to show that the size effect is reasonably big. I admit I have not done that. Is it really all that unreasonable to think, however, that a temporary cut in FICA might help enough to give it a try?

  6. Roger,

    Your idea is controversial for reasons I’ve already explained. It assumes the most naive, static expectations by workers and employers alike.

    Hiring someone is very expensive, and incurs many liabilites, tax and otherwise. Consider when employers do hire temporarily: for expected temporary surges in seasonal demand. So much for the supply side.

    Permament income addresses the demand-side. Even if some workers are hired temporarily, they will save not spend the temporary income.

    I brought up the New Deal because it shows the necessity of effecting a permanent change in spending/policy. Don’t focus on the sopending verus tax cut issue, but the permancey of any change (tax or spending).

  7. Jerry,

    In your opinion would reducing the cost of hiring stimulate hiring?

    If you say yes, then the question at hand would seem to be whether temporarily cutting FICA for employers would (temporarily) reduce such costs,right?

    Let’s momentarily assume the worst possible elasticity of labor supply for my end of the argument: perfectly inelastic. If wage rigidities prevent immediate adjustment to the long-run partial equilibrium tax incidence, then the measure will reduce the costs of hiring,even if labor supply is perfectly inelastic. If labor supply is not perfectly inelastic, then some residual reduction in the cost of hiring will remain even after we move to the the long-run partial equilibrium tax incidence.

    I guess you could argue that the demand for labor is highly inelastic. That seems to be the thrust of your paragraph ending “So much for the supply side.” Maybe. But I’m thinkin’ at least some sectors are flexible enough to take on extra workers on a temporary basis. I think demand curves generally slope downward, no exception being made for labor.

    I continue to acknowledge that I don’t know much about the size of the benefit of trying my suggestion.

  8. To go back to Mario’s post: I agree that none of the analysis asks why there is unemployment whether of labor, capital or land.

    For a time in parts of Las vegas, lots were purchasable for the cost of the utility upgrades installed. The land no longer had locational value. The same can happen to capital, and even to labor in a particular job.

    Resources are unemployed for real reasons and not some confusion over real and nominal magnitudes, or other irrationalities.

  9. Jerry,

    It looks like we’re finally coming together, which is pretty hard to do on a blog! I did not mean to suggest a measure to stimulate aggregate demand. I agree that schemes to stimulate aggregate demand with temporary income-tax cuts don’t really work for permanent-income type reasons. As you now seem to recognize, my suggestion instead goes right to the cost of hiring and works or not regardless of any stimulus to aggregate demand. I agree that for overall recovery the big issue is sectoral balance, not aggregate demand. I should probably have been clearer on these points.

    “Resources are unemployed for real reasons and not some confusion over real and nominal magnitudes, or other irrationalities.” Sure! I don’t think I said anything to the contrary. I tried to affirm the point when I said, “Krugman and Becker undervalue the problem of sectoral readjustment.” Well, “irrationalities” might be playing some role, I suppose. I agree, however, that the big point is the “real reasons” you refer to. Right on.

    My (truly!) modest proposal is a mere stop gap to help out the unemployed. Though I have not said so previously on this thread, such help seems likely to slow, somewhat, the needed sectoral adjustments. You know: Okun’s leaky bucket and all that. (We could probably invent a story about how it would help adjustment, but it seems more reasonable to assume the opposite.)

    You compare my idea to cash for clunkers. Fair enough, except that overall recovery will eventually eliminate the cyclical unemployment addressed by my tax cutting suggestion. My stop gap measure addresses an adjustment problem, not anything long run. As a minor point of strict logic, FICA is an employment tax and has an enduring negative effect on the equilibrium quantity of labor bought and sold, assuming away perfect inelasticity of demand or supply. That’s a very nice point of logic, I suppose, but if my suggestion is any good, it is because it gives temporary relief to the unemployed during the adjustment and recovery period of the trade cycle.

    Thanks to your probing, Jerry, I’ve ended thinking much more than 8 minutes about this idea. Thanks for that, it was all quite stimulating, if I may be forgiven that use of the word.

  10. Roger writes: “I am not forgetting the tax incidence lecture we all give freshmen with, typically, FICA as the big example. But I don’t think labor supply is perfectly inelastic just now. Given wage rigidities, it probably matters in the short run whether you trim the employer’s or the employee’s nominal share.”

    Just trying to get my thinking straight on this: Wouldn’t it be the case that with high unemployment, bosses can push all of “his share” of FICA onto workers, unlike when the labor market is tight? Am I missing something?

  11. Sheldon,

    I don’t think labor supply is perfectly elastic. Recall that tax incidence falls entirely on the supply side only if supply is perfectly inelastic or demand is perfectly elastic. Presumably, you are suggesting supply might be perfectly inelastic. As I said, I doubt that. Basically, we haven’t seen signs saying “Will work for food.” Most unemployed workers have unemployment benefits, or get help from relatives, or draw on saving, or otherwise feel less than totally desperate. As miserable as unemployment is, not many in American today are as desperate as the Depression-era workers who did literally work for food. Thus, the aggregate labor supply curve is probably upward sloping even now.

    The beneficial effect of a cut in the employer’s FICA tax would be augmented in the short run by wage rigidity. If wages are slow to adjust and we cut the employer’s share of FICA, then costs of labor would temporarily jump down for employers even if labor supply were highly inelastic. Similarly, wage rigidity would temporarily dampen the beneficial effects of cutting the employee’s FICA tax. Thus, you would want to cut from the employer’s side first.

    As you can see, I’ve been arguing about the labor market in partial equilibrium micro terms. Jerry took me to be rehearsing some old macro arguments about about aggregate demand that have (rightly, I think) fallen out of favor.

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